ING Direct 2011 Annual Report Download - page 180

Notes to the consolidated annual accounts of ING Group continued
The following methods and assumptions were used by ING Group to estimate the fair value of the financial instruments:
Financial assets
Cash and balances with central banks
The carrying amount of cash approximates its fair value.
Amounts due from banks
The fair values of receivables from banks are generally based on quoted market prices or, if unquoted, on estimates based on discounting
future cash flows using available market interest rates offered for receivables with similar characteristics, similar to Loans and advances to
customers described below.
Financial assets at fair value through profit and loss and Investments
Derivatives
Derivatives contracts can either be exchange traded or over the counter (OTC). The fair value of exchange-traded derivatives is determined
using quoted market prices in an active market and those derivatives are classified in Level 1 of the fair value hierarchy. For those
instruments not actively traded, fair values are estimated based on valuation techniques. OTC derivatives and derivatives trading in
aninactive market are valued using valuation techniques because quoted market prices in an active market are not available for such
instruments. The valuation techniques and inputs depend on the type of derivative and the nature of the underlying instruments. The
principal techniques used to value these instruments are based on discounted cash flows, Black-Scholes option models and Monte Carlo
simulation. These valuation models calculate the present value of expected future cash flows, based on ‘no-arbitrage’ principles. These
models are commonly used in the banking industry. Inputs to valuation models are determined from observable market data where
possible. Certain inputs may not be observable in the market directly, but can be determined from observable prices via valuation model
calibration procedures. The inputs used include prices available from exchanges, dealers, brokers or providers of consensus pricing, yield
curves, credit spreads, default rates, recovery rates, dividend rates, volatility of underlying interest rates, equity prices and foreign currency
exchange rates. These inputs are determined with reference to quoted prices, recently executed trades, independent market quotes and
consensus data, where available.
Equity securities
The fair values of publicly traded equity securities are based on quoted market prices when available. Where no quoted market prices
areavailable, fair value is determined based on quoted prices for similar securities or other valuation techniques.
The fair value of private equity is based on quoted market prices, if available. In the absence of quoted prices in an active market, fair value
is estimated on the basis of an analysis of the investee’s financial position and results, risk profile, prospects, price, earnings comparisons
and revenue multiples and by reference to market valuations for similar entities quoted in an active market.
Debt securities
Fair values for debt securities are based on quoted market prices, where available. Quoted market prices may be obtained from an
exchange, dealer, broker, industry group, pricing service or regulatory service. If quoted prices in an active market are not available,
fairvalue is determined by management based on an analysis of available market inputs, which may include values obtained from one
ormore pricing services or by a valuation technique that discounts expected future cash flows using a market interest rate curves,
referenced credit spreads, maturity of the investment and estimated prepayment rates where applicable.
Certain asset backed securities in the United States are valued using external price sources that are obtained from third party pricing
services and brokers.
In order to determine which independent price in the range of prices obtained best represents fair value under IAS 39, ING applies a
discounted cash flow model to calculate an indicative fair value. The key input to this model is a discount rate derived from an internal
matrix that is used to construct the discount rate per security by applying credit and liquidity spreads relevant to the characteristics of
suchasset classes. The main assumptions in this matrix include:
• a base spread;
• a liquidity risk premium; and
• an additional credit spread, based on:
– seniority in the capital structure – an adjustment is applied to each security based on its position in the capital structure;
– vintage – an adjustment is applied for underwriting guidelines deteriorating from 2004 to 2007 in combination with differences
inhome price developments for these vintages.
The spreads are expressed in basis points and reflect the current market characteristics for credit and liquidity.
The indicative fair value obtained through the discounted cash flow model is then used to select the independently obtained price that is
closest to the indicative price. In addition, judgement is applied in the event that the resulting indicative fair value is closest to the highest
obtained vendor price and that price is a significant outlier compared to other obtained vendor prices. In such cases, the second highest
178 ING Group Annual Report 2011